PDP/02/3 - elibrary.imf.org · Author’s E-Mail Address: [email protected]; [email protected] 1 A version of this paper was presented at a seminar held at the Department of Industrial

PDP/02/3

IMF Policy Discussion Paper

Foreign Direct Investment in China:Some Lessons for Other Countries

Wanda Tseng and Harm Zebregs

I N T E R N A T I O N A L M O N E T A R Y F U N D©International Monetary Fund. Not for Redistribution

© 2002 International Monetary Fund PDP/02/3

IMF Policy Discussion Paper

Asia and Pacific Department

Foreign Direct Investment in China: Some Lessons for Other Countries 1

Prepared by Wanda Tseng and Harm Zebregs

February 2002

Abstract

The views expressed in this Policy Discussion Paper are those of the author(s) and do notnecessarily represent those of the IMF or IMF policy. Policy Discussion Papers describeresearch in progress by the author(s) and are published to elicit comments and tu further debate.

China's increasing openness to foreign direct investment (FDI) has contributed importantly to itsexceptional growth performance. This paper examines China's experience with FDI andidentifies some lessons for other countries. Most of the factors explaining China's success havealso been important in attracting FDI to other countries: market size, labor costs, quality ofinfrastructure, and government policies. FDI has contributed to higher investment andproductivity growth, and has created jobs and a dynamic export sector. China's success,however, did not come without some pitfalls: an increasingly complex tax incentive system andgrowing regional income disparities. Accession to the WTO should broaden China's "openingup" policies and continue FDFs contributions to China's economy in the future.

JEL Classification Numbers: F2I

Keywords; China, Foreign Direct Investment

Author's E-Mail Address: [email protected]; [email protected]

1 A version of this paper was presented at a seminar held at the Department of IndustrialPolicy and Promotion in Delhi, India on November 12, 200 L The authors are grateful to anumber of colleagues for useful comments and inputs: Christopher Towe, James Gordon,Markus Rodlauer, Ray Brooks, Paul Heytens, Jahangir Aziz, Patricia Reynolds,Jingqing Chai, Christina Daseking, Alex Lehman, and Yongzheng Yang, and Anna Maripuufor research assistance.

©International Monetary Fund. Not for Redistribution

- 2 -

T. INTRODUCTION

1. The market-oriented reforms and "opening up" policy pursued by China have

produced high economic growth and a dramatic economic transformation. Since the start

of reforms in 1978, real GDP growth has averaged 91A percent, raising per capita income five

fold and enabling China to make unprecedented strides in reducing poverty. The nonstate

sector is now estimated to account for about 60 percent of GDP. A driving force for this

exceptional growth performance has been the increasing openness of the economy, especially

to trade and foreign direct investment (FDI). Indeed, attracting FDI has been a key pillar of

China's "opening up" policies.

2. This paper looks into the questions: What explains China's success in attracting

FDI? Can it be replicated by other countries, or is it unique to China? Has China benefited

from the large inflow of FDI? What lessons can China's experience with FDI offer for other

countries?

3. The paper is organized as follows: It begins with an overview of the key trends and

characteristics of FDI to China and touches on the question whether, at the start of reforms in

the late 1970s, China was in an economically better position to develop a potential for

attracting large amounts of FDI than other countries, such as India. It then discusses the

determinants of FDI in China, the impact of FDI on China's economy, and identifies some

tentative lessons from China's experience with FDI.

II. KEY TRENDS AND CHARACTERISTICS OF FDI IN CHINA

4. FDI inflows to China have surged from almost nil at the start of the reform in the

late 1970s to USS40-45 billion per year in the second half of the 1990s (Table 1 and


- 3 -

Chart 1). The surge occurred in the early 1990s, following Deng Xiaoping's tour of the

southern coastal areas where he reaffirmed China's continued commitment to reforms and

policies to open up the economy to the outside world. The tour ushered in an era of renewed

confidence and entrepreneurship. Although FDI inflows declined slightly during the Asian

financial crisis, they picked up again in 2000 partly in anticipation of China's WTO

19E4-S9 1990s 1990-94 1995-99

(period averages)FDI

In billions of US dollarsIn percent of GDP[n pcccnt of Total FDI flowsto developing countries

Annual GDP growth

Sources: tiuluncu oj'Paytnst

2.30.7

12.7

9.7

2S.34.4

24.3

10.1

16 ,13.7

27.1

12 2

40.64.7

23.3

8.3

to Statistics YaarbiMk; C-hrna Statistical Yearbook;and fnternaiitmal Financial SiaJimivti.

accession. In percent of GDP, FDT inflows rose from almost nil to about 5 percent during the

reform period. By the 1990s, China became the second largest FDI recipient in the world,

after the United States, and by far the largest recipient of FDI among developing countries,

accounting for about 25-30 percent of FDI flows to all developing countries.

5. However, part of China's success in attracting FDI may be exaggerated because

of misreporting and round-tripping. The latter refers to capital originating from China that

returns disguised as FDI to take advantage of tax, tariff, and other benefits. The extent of this

round-tripping is difficult to assess; estimates range from 7 percent of inflows in 1996 to

almost 25 percent of inflows in 1992.2 Some FDI is actually better characterized as foreign

borrowing as these inflows (mainly for infrastructure) were promised a guaranteed rate of

2 Harrold and Lall (1993), Lardy (1995), and Wei (1998).

Chart J. China: FDJ Inflows, I'J85-20M(in burtons, nl UScJa/ka-'i)

Table 1. China: FDI inflows and GDP growth, 1984-99


- 4 -

return. The data may also be affected by misreporting, as local officials have an incentive to

exaggerate their ability to attract FDI and foreign investors have an incentive to overstate the

actual investment to report lower taxable income.

6. As for the sources of FDI in China, Hong

Kong SAR and Taiwan Province of China have

traditionally been the most important ones

(Table 2). The importance of these two economies as

sources of FDI diminished somewhat in the 1990s as

multinationals from Europe, Japan, and the United

States entered China, but Hong Kong SAR and

Taiwan Province of China still account for

Total

Hong KonjtSAKJapanTaiwan Province of ChinaUnited SlatesEuropean UnionSingaporeKorea

Other

1<»1

100

55.311110.17.15.71.20.0

7.5

1995

100

53.4R.58,48.25,74,92 S

8.2

1999

100

4].07.2ft. 59.9

11.0f..23.0

lf .1

Source! Siaiixticaf Yearbook af'CItina .

almost half of FDI in China.

7. In terms of sectoral distribution of

FBI, the largest portion of FDI is destined

for manufacturing, which took up almost

60 percent of total contracted FDI (Chart 2).

Next is real estate at 24 percent, followed by

distribution (e.g., transport, wholesale, and retailing) at 6 percent. Among the manufacturing

sectors, about half of FDI has been directed toward labor-intensive manufacturing

(e.g., textiles and clothing, food processing} furniture). Technology-intensive manufacturing

(e.g., medical and Pharmaceuticals, electrical machinery and equipment, electronics) and

capital-intensive manufacturing (e.g., petroleum refining, chemical materials) almost share

iairec OLfll. 2UOO.

CKait2. China. Sectoral Distribution of FDI(in percent {if total ctmtratled value, i99H)

l aHe2 China. Sources of FDJ, 1991-99

(In percent of total)


- 5 -

Chart 3, Chnia: Geographical Distribution of FOI, 19S3-1998(hi percum of total}

equally in the remainder. This suggests that an important motivation for foreign companies

was to take advantage of China's low labor costs.

8, In terms of geographical distribution, the FDI pattern in China shows a great

disparity among regions. The eastern region (accounting for 64 percent of GDP) took up

nearly 88 percent of FDI to China while

the central region (29 percent of GDP)

took up 9 percent and the western region

(23 percent of GDP) attracted only

2 percent (Chart 3). This pattern stems

from the FDI policies pursued by the

Chinese authorities and reflects the

incremental nature of the reform process in China. Much of the early reform consisted of

experiments in selected regions and sectors—this allowed the authorities to assess the results

of these experiments before extending them to other parts of the country. The "open door"

policy started with the creation of the Special Economic Zones (SEZs) (Section III below) in

the southern provinces of Guangdong and Fujian at the outset of reforms in the late 1970s,

followed by the opening of another SEZ in Hainan and 14 coastal cities in 10 provinces in

the 1980s. This has resulted in an overwhelming concentration of FDI in the eastern part of

the country. When the authorities adopted more broadly based economic reforms and open

door policies for FDI in the 1990s, FDI started to spread to other provinces.

9. Turning now to forms of FDI, equity joint venture companies, cooperative joint

venture companies, and wholly foreign-owned enterprises have been the main forms of

Suurec:[«iC]> JIWCI


- 6 -

absorbing of FDI into

o

China. Early in the reform

period, China allowed only

joint ventures as the entry

form for FDI (except in the

SEZs) for ideological

reasons and because the

authorities thought this form was better suited to tapping advanced technology. It was not

until 1986 that wholly foreign-owned enterprises were permitted in areas outside the SEZs.

Accordingly, equity and cooperative joint ventures had accounted for the lion's share of FDI

(Chart 4). Recent trends, however, show that FDI is increasingly directed into wholly foreign-

owned enterprises, which accounted for more than half of total commitments in 1999,

10. It appears that at the start of the reform process in 1978, China was not evidently

better placed to attract large amounts of FDI than, for example, India, which shared a

number of characteristics with China (Table 3). Both countries had relatively closed

economies, with low income levels and a large share of the population dependent on

agriculture. Neither China nor India was receiving significant amounts of FDI. This picture

has changed dramatically since then, as a result of China's economic reforms and "open door"

policy. While India's GDP per capita more than doubled between 1978 and 2000. China's

•J

Under an equity joint venture, Chinese and foreign investors operate the venture and sharethe risks, profits, and losses jointly. All parties involved agree on the equity share of eachparty. Profits are distributed to the parties in proportion to their equity share. In a cooperativejoint venture, the Chinese partner provides land, natural resources, labor, andequipment/facilities, while the foreign partner provides capital/technology, key equipment,

(continued)

Chart 4. China: Forma of FDIfin percent ttf toutl wniracied value)

Simrtia1 OTCn If KM)


- 7 -

GDP per capita quadrupled (in

constant U.S. dollar terms).

India still remains a fairly

closed economy while China

has become more integrated

into the global economy,

11. China's increasing

openness to the outside world

can be seen in the rapid

growth of its foreign trade.

Table 3. China and India: Selected Economic Indicators

197*China

GDP per capita (in constant US dollars)

External Trade and Investment:Current account balanceExports of goodsImports of goods

Net inward FDI HowsNet inward FDI flows (in percent of total investment)

Composition of output:Primary sector value addedSecondary sector value addedTertiary seclor value added

225.1

0.34.65.2

0.00.0

28.148.223.7

2000India China India

196,8 855.0

(In percent of GDP)

0.1 1.95.1 19.16.8 23.1

0.00 . 1

3S.625.635.7

3.69.8

15. 950.933.2

467.4

-0.79.2

12.4

0.41.9

25.926 J48.0

Sources: International Financial Statistics', and China Statistical Yearbook.

Exports and imports as a share of GDP rose from negligible amounts to nearly 25 percent

in 2000 (Table 4). The average tariff rate in China fell from well over 50 percent in the

early 1980s to about 15 percent now. less than half of that in India. Equally important,

because China exempts so many goods

entirely from import duties and because

a significant share of imports of goods

subject to high tariffs are imported

illegally, actual tariff collection as

a percent of the total value of imports

has been much lower. The collection

rate, that is tariff revenue as a percent of

Table 4 China and India: Openness Indicators

All figures are 2000, unless otherwise noted China

Share in world trade flowsExports of goods and services (in percent of GDP)Imports of goods and services (in percent of GDP)Average tariff rate (China 2001, India J999)Effective tariff rate (1998) 1/Share oTUriff revenue in total government revenue (1998)

I/ Tariff revenue/Import value.

3.725.923.215.32.86.3

India

0.713.116.032.923.020.1

Sources: Government Finance Statistics; International Financial Statistics ;and Fund staff estimates.

and materials. Both parties decide on the proportions in which products, revenue, and profitsare distributed. A wholly foreign-owned venture is wholly owned by foreign investors.


total imports, is only 3 percent in China, compared with 23 percent in India. Net FDI inflows

into China in 2000 were more than 15 times that of India,

III. MAIN DETERMINANTS OF FDI IN CHINA

12. Studies of FDI in China have shown that the determinants of FDI in China are

not unique to China but have also been important in attracting FDI to other emerging

economies.4 Two types of FDI flows can be considered: domestic-market oriented flows and

export-oriented flows. Domestic-market FDI is mostly motivated by the size and growth of

the host country. Export-oriented FDI mainly looks for cost competitiveness.

13. The factors that have been most important in influencing FDI in China can be

grouped into three categories: economic structure, liberalization and preferential

policies, and cultural and legal environment.

Economic Structure

14. Market size. Both at the national and the provincial level, empirical studies have

found a strong correlation between GDP and FDI inflows in China.5 The causality between

the two variables runs in both directions; FDI has been attracted by the enormous market

potential that China has to offer, and has at the same time contributed to GDP growth through

various channels (discussed below). It appears that market size has been more important as a

determinant of FDI from Europe and the United States than for FDI from Hong Kong SAR

and Taiwan Province of China, as the latter tends be more export-oriented. In contrast, many

4 Cheng and Kwan (2000) and Liu et al. (1997).

5 Cheng and Kwan (2000), Liu et al. (1997), Zebregs (2001), and Zhang (1999).

6 Zebregs (2001) and Zhang (1999).

- 8 -


- 9 -

European and American multinationals have set up factories in China with the aim to produce

for the domestic market,

15. Abundant supply of cheap labor. Although the empirical evidence is somewhat

mixed, low wage costs appear to have played a significant role In attracting FDI to China and

*j

in the distribution of FDI flows across provinces. Some analysts have suggested that low

wage costs have especially been an important factor in attracting export-oriented FDI from

Hong Kong SAR and Taiwan Province of China as a response to rising wage costs in their

own and other economies in the region. Hiis has contributed to China's rapid emergence as an

important global competitor in labor-intensive manufacturing. While the quality of labor has

not been found to be a significant determinant of FDI in China in most empirical studies—

indeed the shortage of highly qualified personnel has been a problem often noted by foreign

investors—this will likely change in the future as China's comparative advantage evolves

toward higher value-added manufacturing,

16. Infrastructure. Empirical studies confirm that provinces in China with more

developed infrastructure have tended to receive more FDL8 This partly explains the

concentration of FDI in the eastern coastal areas with their superior infrastructure and

transport links to external markets. The devolution of investment decisions to local

governments, particularly in Open Economic Zones9 (OEZs), allowed them to upgrade

infrastructure in an effort to attract FDI (Table 5). Of the increase in fixed asset investment

7 Chen (1996), Cheng and Kwan (2000), Head and Ries (1996), and Liu et al. (1997).

s Cheng and Kwan (2000), and Head and Ries (1996).

9 Open economic zones include SEZs, open coastal cities, and various development zones.For a taxonomy of the different types of zones see Box 1 and Wall, Jiang, and Jin (1996).


-10 -

Table 5. China: Infrasiruclure Indicators

1990 1WS

Power

Electric power consumption (kwh per capita)

Electric power transmission and distribution Josses (in percent of output}

Tra ns portation

Air transport, freight (million ions -km)Roads, goods transported (billion tons -kin]

Communications

Telephone mainlines (per 1,000 people}

Mobile phones (per 1 ,000 people)

Telephone, average cost of call to US (USJ per three minutes)

Telephone, average cost of local call (US$ per three minutes)

Internet hosts (per 10,000 people)

471.00 746.00

7.50 7.10

SLS.GO 3,345.00

336.00 548.00

5,90 69.60

0.02 19,00

6.70

0.01

0.00 0.20

Source: World Bank, World Development indicators.

from the late 1980s to the

late 1990s (by 61A percentage

points of GDP) about

3 percentage points were

accounted for by local

governments and were mainly

in infrastructure, particularly

electricity, gas, and water,

transport, post, and

telecommunications.

17. Scale effects. Several studies have found a strong persistency in FDI flows. This is

the case not only for total FDI flows to China, but also for FDI flows to China's provinces.

This suggests that once a province has attracted a critical mass of FDI, it will find it easier to

attract more FDI as foreign investors perceive the presence of other foreign investors as a

positive signal. In addition, economies of scale make it more efficient for foreign

multinationals to locate in the same area, which allows them to share information and

facilities, such as schools and health facilities for expatriate workers. The coastal provinces, in

particular the southern provinces of Guangdong and Fujian, which are close to Hong Kong

SAR and Taiwan Province of China, have been the largest recipients of FDI and have

acquired an important advantage over the inland provinces in attracting FDI over the past two

decades.

10 Cheng and Kwan (2000) and Head and Ries (1996).


-11 -

Reduced Barriers and Preferential Policies

18. The reduction of barriers to FDI and policies to improve the investment

environment have played a key role in attracting FDI to China. From the beginning of the

reform process, the Chinese authorities considered attracting FDI as an important goal as it

would introduce new technologies, know-how and capital, and help to develop the export

sector. However, they also recognized that it posed a risk to state control. In addition, the

authorities had to overcome "ideological obstacles" to FDI that were rooted in the historical

legacy of the opening of Chinese port cities by the Western powers after the Opium War: this

legacy left a tendency to equate FDI with imperial colonialism and the exploitation of China

by "Western capitalists". These factors affected the evolution of FDI policies in China,

Initially, laws and regulations tended to be too restrictive and many bureaucratic and legal

problems were encountered. Over time, the authorities responded to addressing the complaints

of foreign investors. This was done by clarifying the legal environment for FDI, relaxing

governmental controls, and providing practical assistance, as well as political and legal

assurances (Box 1). From an experiment limited to a few localities and sectors at the outset of

reforms, more and more regions and economic sectors were opened to FDI by the 1990s.

19. The preferential policies to attract FDI have been tax concessions and special

privileges for foreign investors, and the establishment of QEZs (Box 2). Tax incentives

for foreign funded enterprises (FFEs) are mostly in the form of reduced enterprise income tax

rates and tax holidays (Box 3). They are available to all FFEs in OEZs and to export-oriented

and advanced technology FFEs outside the OEZs. as well as to domestic firms in the OEZs. In

addition, firms in OEZs enjoy a high level of autonomy in managing operations, as they face


-12-

Box 1, China's FDI Regime

FDI in China was highly restricted prior to 1978. Since then, the FDI regime has beenliberalized gradually. A legal framework for FDI was progressively developed to facilitateand regulate FDI. China's accession to the WTO promises further FDI liberalization.

Key laws and regulations on FDI

The legal framework for FDI has been progressively codified and clarified:

1919 Law on Joint Ventures Using Chinese and Foreign Investment provided a basicframework for the establishment and operation of foreign economic entities. It specified avariety of incentives and terms for joint ventures.

1983 Regulations for the Implementation of the Law on Joint Ventures Using Chinese andForeign Investment provided greater details on the operations and preferential policies forjoint ventures.

1986 Law on Enterprises Operated Exclusively with Foreign Capital formally permitted theestablishment of wholly foreign-owned enterprises outside SEZs.

1986 Notices for Further Improvements in the Conditions for the Operation of ForeignInvested Enterprises and Provisions of the State Council for Encouraging ForeignInvestment provided further incentives, particularly for FDI using advanced technologiesand/or producing for exports. These provisions were subsequently codified in the 1988Cooperative Joint Ventures Law.

1990 Amendments to the Equity Joint Venture Law and Wholly Foreign-Owned EnterpriseImplementing Rules provided a more complete legal structure to facilitate the operations ofthese enterprises. Notably, these laws/rules abolished the stipulation that the chairman of theboard of a joint venture should be appointed by Chinese investors and provided for protectionfrom nationalization.

1995 Interim Provisions on Guiding Foreign Direct Investment Direction (revised in 1997)classified FDI into four categories (see below).

Industrial Guidance for FDI

The Interim Provisions on Guiding Foreign Investment Direction (revised edition 1997)classify four categories for FDI: encouraged, permitted, restricted, and prohibited. The


-13 -

Box 1* China's FDT Regime (concluded)

regulations aim to encourage greater geographic dispersion of FDI inflows within China, andpromote FDI inflows into targeted sectors and industries, such as export-oriented and hightechnology industries, agriculture, and infrastructure.

In broad terms, projects are encouraged and permitted in designated industries that introducenew and advanced technologies, expand export capacity, raise product quality,, and use localresources in the central and western regions. Restricted and prohibited are projects indesignated sectors that make use of existing technologies, compete with domestic productionor state monopolies, make extensive use of scarce resources, or are deemed to be a danger tonational safety and the environment.

Sectoral Limits on FDI

Foreign participation in certain economic sectors/industries is limited; in particular;

regulations specify (i) industries where Chinese partners must play a leading role or have amajority share; and (ii) industries where wholly foreign-owned enterprises are not permitted.These restricted industries include "strategically" important infrastructure projects, such asairports, nuclear power plants, oil and gas pipelines, subways and railways, water projects; aswell as projects in aerospace, automobiles, defense, high-tech vaccines, medical institutions,mining, petrochemicals, printing and publication, shipping, satellite communications, andtourism. About half of these industries are considered high-technology industries.

WTO Agreement on FDI

China has made substantial commitments in trade and investment liberalization uponaccession to the WTO. General commitments include nondiscriminatory treatment of foreignand domestic enterprises, adherence to WTO rules on intellectual property rights, andelimination of various requirements on FDT, including foreign exchange and trade balancing,technology transfer, local content, and export performance.

Sectoral commitments involve significant expansion of market access, particularly in theservices sector. These involve eliminating geographic and other restrictions in key sectors(e.g., motor vehicles) and increasing foreign ownership limits in telecommunications(50 percent by 2002), life insurance (50 percent on accession), distribution and retailing,securities (49 percent by 2003), and giving full national treatment to foreign banks (by 2005).

See Foreign Investment Administration (1998); MOFTEC; and Tax Exemption Policies onImportation of Equipment by Enterprises with Foreign Investment, MOFTEC.


-14-

Box 2. Open Economic Zones in China1

Since the beginning of economic reforms, a variety of open economic zones have emerged., whichhave offered a more liberal investment and trade regime than other areas, as well as special taxincentives. While open to both domestic and foreign investors, these zones have played an importantrole in attracting FDI, although most of the investment in the zones has come from domestic sources.

Special Economic Zones (SEZs)SEZs were the first, and until 1984 only, open economic zones, Four SEZs were established in 1980,three (Shenzhen, Shantou, and Zhuhai) in Guangdong Province near Hong Kong SAR, and one(Xiamen) in Fujian Province, close to Taiwan Province of China. In 1988, Hainan Province becamethe fifth SEZ,

SEZs have enjoyed considerable autonomy in their investment policies regarding both infrastructureprojects (provided they can be financed locally) and investment approvals (for projects upto$30 million). They have offered preferential income tax treatment, and exemptions from importlicenses (for FFEs automatically, for domestic enterprises subject to approval) as well as tax and tariffconcessions for raw materials, intermediate and capital goods (concessions for the latter wererescinded in 1996). Within SEZs, sales of locally produced goods have been free from duties andtaxes, and sales of imported goods have been subject to a reduced tariff, with full tariffs and dutiesapplying to sales outside SEZs (except exports).

Open Coastal Cities (OCCs)In 1984, 14 cities in the coastal regions with already established industrial bases and infrastructurebecame OCCs and were opened to foreign investment. Although not separate customs areas and lessindependent than SEZs, OCCs have enjoyed greater flexibility in investment and tax policies thanother regions in China. Several OCCs and the surrounding counties have created larger "developmentareas," such as the Pearl River delta and the Yangtze delta (including Shanghai).

Economic and Technology Development Zones (ETDZs)Within the 14 OCCs, special areas were set aside for ETDZs, offering tax incentives similar to thosein SEZs. Further ETDZs in the Yangtze valley, as well as border and inland cities, were subsequentlyapproved by the State Council. The largest ETDZ, the Pudong New Area, opened in 1990.

High Technology Development Zones (HTDZs)HTDZs emerged in the early 1990s. In most features similar to ETDZs, HTDZs have placed particularemphasis on attracting investment in high technology industries by providing additional taxconcessions.

Free Trade Areas (FTAs)

The first two FTAs were established in the early 1990s in Pudong and Shenzhen, and a number ofothers have been opened since then. Exports and imports can be traded freely within FTAs andenterprises are free to engage in bonded entrepot trade as well as export-oriented production.

1 Source: IMF (1997); Wall, Jiang, and Yin (1996).


-15-

Box 3. Tax Incentives for FDI

China has extensively but selectively used tax incentives to guide FDI into designated regions, economic sectors andindustries. Foreign-funded enterprises (FFEs) enjoy exemptions and reductions in the national business income taxand other incentives including exemptions of custom duties and the value-added tax for imported equipment andtechnology, exemptions and reductions in local business income tax, full refunds for income tax paid on reinvestedearnings, and no restrictions on profit remittances and capital repatriation. Generally speaking, the tax incentivesoffered in the SEZs and Economic and Technology Development Zones (ETDZs) in open cities are much morefavorable than in other regions (see below). Also, the tax incentives are more favorable for technology and export-oriented FFEs.

In 1994, China adopted a new taxation system which unifies the taxation treatment of domestic enterprises and FFEs,At the same time, China decided to reduce gradually the preferential treatment for FFEs in order to establish a levelplaying field for both types of enterprises. With the implementation of this policy, the preferential policies, includingtax incentives, will be gradually reduced and abolished,

Standard Income Tax RatesDomestic enterprises: 33 percent

FFEs: 33 percent.1 FFEs with contracts for operating periods of 10 years or more are exempt item income tax for2 years after the first profit is realized, and eligible for a 50 percent reduction in their tax liability in the following3 years. FFEs that export at least 70 percent of their annual output remain eligible for a 50 percent reduction afterthese five years. Advanced- technology FFEs receive a 50 percent redaction for 3 years after the initial 5 years.

Special Economic ZonesDomestic enterprises: 18 percent

FFEs: 18 percent1 and the same 2-year exemption, 3-year reduction as under the standard income tax regime. Export-oriented and advanced technology FFEs pay 10 percent (instead of 15 percent) after the initial 5-year exemption andreduction period has expired. FFEs engaged in infrastructure projects in Hainan (airports, harbors, docks, railroads,highways, power plants, and water conservation) and with contracts for operating periods of 15 years or more areeligible for a 5-year exemption period followed by 5 years at a reduced rate (10 percent instead of 15 percent) afterthe first profitable year.

Open Coastal Cities and Areas, Open Boarder Cities, Inland Provincial Capitals, and Yangtze River OpenCitiesDomestic enterprises: 33 percent

FFEs: 27 percent1 and the same 2-year exemption, 3-year reduction as under the standard income tax regime. Forprojects with foreign investment of $30 million or more (registered capital) and a long recovery period, knowledge-or technology-intensive projects, and energy, transportation or harbor construction projects, the 24 percentcomponent may be reduced to 15 percent.

Economic and Technology Development ZonesDomestic enterprises: IS percent

FFEs: 18 percent1 for all production-related FFEs, with the same 2-year exemption, 3-year reduction as under thestandard income tax regime. For export-oriented and advanced technology FFEs, the same extended reductions as inthe SEZs apply.

High Technology Development ZonesDomestic enterprises: 18 percent

FFEs: 18 percent1 and the same exemptions and reductions as under the standard income tax regime for high or newtechnology enterprises,

'includes a 3 percent local government component on which local governments may grant reductions.


-16-

minimal controls on goods movements, and are allowed to export and import almost freely.

Firms in the OEZs also benefit from more flexible labor relations and more liberal land use.

Additional benefits are available for export-oriented and advanced-technology FFEs?

including tax exemption on profit remittances, additional tax benefits for reinvested profits,

and larger reductions in land-use fees.

20. OEZs have played a central role in the gradual opening of the economy to foreign

investors. In the early reform period, one important difference between the OEZs and other

areas in China was the administrative decentralization that permitted investment decisions in

the OEZs to be taken largely outside the state plan. Local authorities in the OEZs were

allowed to attract foreign investors through preferential policies. They were also allowed to

undertake their own infrastructure development and other investment as long as they could

raise the funds from taxation, from profits of the enterprises they own wholly or partly., or

from banks in the zones. Although the zones have provided favorable business conditions, a

number of important constraints—such as restricted access to foreign exchange and domestic

markets—remained in place in the early reform period. This largely limited the business

scope of foreign enterprises to export-oriented activities. When these restrictions were eased

in the second half of the 1980s, foreign investors gradually gained access to the domestic

market and, as a result, links with the domestic economy increased.

21, The international empirical evidence on the impact of preferential policies on

FDI flows is mixed, and more work is needed to assess the impact in the case of China.11

What is clear is that in the political economy context of China's reform process, preferential

n See Chalk (2001).


- 17-

policies provided a means for incremental experiments with economic reforms that was

acceptable to the political leadership. Reforms were initially confined to certain localities and

FFEs and gradually extended more broadly. In this environment, the success of OEZs in

China suggests that preferential policies were useful in catalyzing economic development and

attracting FDI. In the absence of preferential policies, FD1 would likely to have been

substantially less, given the restrictive environment in which Chinese enterprises outside the

OEZs had to operate. Thus, it can be argued that preferential policies yielded a net gain to the

economy—by allowing reforms to take hold and by attracting FDI which contributed to

output growth. However, over time as the reform process advanced, preferential policies

created distortions and inequities, particularly a complex and biased tax system and regional

income disparities, that need to be addressed.

Cultural and Legal Environment

22. Shared cultural background. It has often been argued that China's success in

attracting FDI is unique because of the large Chinese Diaspora. The fact that

Hong Kong SAR, Singapore, and Taiwan Province of China account for more than half of

FDI inflows into China is usually used to support this argument. While many other countries

do not share this characteristic, it could be argued that the large share of nonresident Chinese

hi FDI flows into China is a reflection of distortions rather than a unique advantage. Cultural

barriers, such as the language, which prevent foreign investors from entering China, could be

a sign that the investment climate is too difficult for outsiders, which implies a cost.


-18-

23. Corruption and legal environment. These are two important factors that have been

found significant in explaining FDI to many countries. In the case of China, many foreign

investors perceive the legal system as ambiguous, and legal disputes often are settled through

personal contacts rather than formal contracts that are enforced by the court. The ambiguity in

the law has, in turn, contributed to corruption. China scores relatively low on corruption and

governance indicators in international comparisons (Chart 5). This situation has deterred

foreign investment from Europe and the United States more than investment from Hong Kong

SAR and Taiwan Province of China. Familiarity with the local culture helps in passing

bureaucratic hurdles and that is one of the reasons why investors from Europe and the United

States have often sought local counterparts. One study found that China could attract more

Source: Transparency International

12 Wei (2000).

Chart 5. Transparency International 2001 Corruption Index

for Selected Countries


-19-

FDI from Europe and the United States were it not for the implicit tax imposed by

bureaucratic hurdles.

IV. IMPACT OF FDI IN CHINA

24. FDI flows to China have contributed to GDP growth in several ways:

• FDI has raised GDP growth by adding to capital formation. This effect is

estimated to have contributed about 0.4 percentage points to annual GDP growth in

the 1990s. The direct contribution of FDI to GDP growth has been highest in

provinces that have attracted most foreign investment and ranged from almost

4 percentage points per year in Guangdong to negligible amounts in most inland

provinces.

• FDI has contributed to higher GDP growth through its positive effect on total

factor productivity (TFP). Empirical research suggests that FDI has raised TFP

growth in China by 2.5 percentage points per year during the 1990s. Again, this effect

was found to be strongest in provinces that have received most FDI. Thus, in sum, FDI

has contributed nearly 3 percentage points to potential GDP growth for China.

25. FDI has contributed to GDP growth directly through the establishment of FFEs

and indirectly by creating positive spillover effects from FFEs to domestic enterprises.

FFEs tend to be the most dynamic and productive firms in China's economy. Output of FFEs

in the industrial sector has expanded at four times the rate of other industrial enterprises

during 1994-97, while their labor productivity is almost two times that of public sector

13 Wei (1998).

l4Zebregs(2001).


-20-

enterprises. In addition, empirical research has found that domestic enterprises appear to have

benefited from the presence of FFEs, both through Increased sales and positive spillovers.15

The latter come about when FFEs introduce new technologies and management skills. These

externalities are thought to have become progressively more important as more links began to

develop between FFEs and domestic enterprises in the 1990s.

26, FDI has created employment opportunities. The creation of employment

opportunities—either directly or indirectly—has been one of the most prominent impacts of

FDI in China. Looking only at the direct effects, employment in FFEs in urban areas

quadrupled between 1991 and 1999. to a total of 6 million, accounting for 3 percent of

China's urban employment. This has been particularly important in ameliorating

unemployment pressures stemming from ongoing reforms of state-owned enterprises. FFEs

are particularly important employers in the coastal provinces, accounting for over 10 percent

of urban employment in Guangdong, Fujian, Shanghai, and Tianjin as of 1999.

27. FDI has built a highly competitive and dynamic manufacturing sector for

exports. The growth of China's trade since 1978 has been four and a half times that of world

trade, and China's share of world trade quadrupled from 0.9 percent in 1978 to 3.7 percent

1 ""7in 2000—an achievement that has not been matched by any other country, FFEs played a

key role in this achievement. Between 1985 and 1999, the share of exports accounted for by

15Zebregs(2G01)+

16 It is difficult to measure the indirect employment effects of FDI; these include theemployment indirectly generated as a result of spending by FFEs, or as a result of linkages ofFFEs with domestic enterprises., either as competitors or as suppliers and customers.

17 Lardy (2000).


-21 -

FFEs grew from 1 percent to 45 percent; FFEs accounted for half of overall export growth

and one-third of import growth during this period.

V. CONCLUSIONS

28. While more work is needed to flesh out the lessons from China's experience with

FDI, some tentative conclusion may be drawn. Factors important in attracting FDT to other

countries have also been key to China's success. China's large domestic market, low wage

costs, and improved infrastructure, complemented with open FDI policies, especially the

establishment of OEZs, seem to have been major factors in attracting FDI, But China could

probably attract even more FDI if governance improved and China's legal system became

more effective in enforcing contracts.

29. A unique factor in China's success is the large presence of investors from two of

the most dynamic economies in the regions: Hong Kong SAR and Taiwan Province of

China. Although part of the FDI flows from these economies may be induced by distortions,

the fact remains that, together with Singapore, they have accounted for more than half of the

FDI flows to China.

30. Apart from the economic environment, political commitment is an important

ingredient in attracting FDI. It was shown, for example, that India shares with China many

of the structural factors that have been important determinants of FDI—market size, abundant

labor, and a large Indian Diaspora. So, a priori, there seems to be no reason why India could

not become an attractive destination for FDI if it so chooses. There is of course a big

difference in how political choices are made among countries. In China, the political

leadership imposed a vision for the path of growth and development of the country.

Nevertheless, China had to overcome the obstacles to FDI rooted in history and ideology. The


-22-

political leadership did so by limiting the opening to a few localities initially, but even then, a

great deal of autonomy in economic decisions was given to the localities—allowing a market-

based economy to develop alongside a centrally planned system. Although this

decentralization created some problems, it also gave local authorities strong incentives to

grow and develop their economies. The success of the initial experiments created strong

demonstration effects, which induced broad support for further reforms and opening up. This

created a virtuous cycle as reforms produced economic fruits, support for reforms became

more widespread, allowing more reforms to be implemented.

31. China's experience shows that FDI contributes to GDP growth. The effect is likely

to be strongest if foreign enterprises develop close links with domestic enterprises, so that the

impact of FDI on productivity growth is extended beyond the firms receiving FDI.

32. FDI will continue to contribute to China's economic development. WTO accession

is expected to lead to a continuation of these contributions as FDI can be expected to increase,

particularly in the services sector, such as finance, telecommunications, and wholesale and

resale commerce, FDI will continue to be an important source of growth and will help offset

potential output losses and create employment opportunities for workers that have become

redundant in state enterprise and banking reforms. It is significant that the Chinese authorities

have invited foreign participation in the restructuring of state-owned enterprises and the

resolution of the nonperforming loan problems in the banking sector. In sum, FDI can be

expected to continue to play an important role in China's reform process for some time to

come.

33. There are also some pitfalls in China's FDI experience that provide lessons for

other countries. In particular:


-23-

• An increasingly complex and biased tax incentive system. The tax incentive system

is heavily targeted at FFEs relative to domestic enterprises. Indeed, two different

enterprise income tax laws apply to foreign funded and domestic enterprises. With the

proliferation of OEZs and the widening of the range of eligible activities, China's

system of enterprise income tax incentives has become increasingly complex and

nontransparent, not to mention revenue losses for the government. This problem has

become more prominent with China's accession to the WTO, as certain of the fiscal

incentives do not conform with the WTO principles of national treatment and

prohibition of export and import-replacement subsidies. China is in the process of

amending various laws to meet its WTO commitments.

• Growing regional inequalities. By focusing on specific regions, China's FDI policy

has contributed to the growing income disparity between the coastal and inland

provinces. The Chinese authorities are giving priority to reducing regional income

disparities by developing the western and central regions of the country, including by

attracting FDI to these regions through increased investment in infrastructure.


^ 94 -£*i

References

Chalk, Nigel, 2001, "Tax Incentives in the Philippines: A Regional Perspective,"IMF Working Paper, WP/01/181.

Chen, C., 1996, "Regional Determinants of Foreign Direct Investment in Mainland China/'Journal of Economic Studies. 23. pp. 18—30,

Cheng, L.K. and Y.K. Kwan, 2000, "What Are the Determinants of the Location of ForeignDirect Investment? The Chinese Experience/' Journal of International Economics^ 51,pp. 379-400.

Harroid, Peter and Rajiv Lall, 1993, "China, Reform and Development in 1992-93",World Bank Discussion Papers, No. 215.

Head, K, and J. Ries, 1996, "Inter-City Competition for Foreign Direct Investment: Static andDynamic Effects of China's Incentive Areas," Journal of Urban Economics, 40,pp. 38-60.

International Monetary Fund, 1997, "People's Republic of China—Selected Issues," IMFStaff Country Reports, No. 97/72.

Lardy, Nicholas, 1995, 'The Role of Foreign Trade and Investment in China's EconomicTransformation," China Quarterly, No. 144, pp. 1065-82,

Lardy, Nicholas, 2000, "Is China a "Closed" Economy?" Statement for a Public Hearing ofthe United States Trade Deficit Review Com mission, February 24, 2000.

Li, Feng and Jing Liu, 1999, Foreign Investment in China, New York, St. Martin's Press.

Liu, X.. H. Song, Y. Wei, and P, Rom illy, 1997, ''Country Characteristics and Foreign DirectInvestment in China: A Panel Data Analysis/7 Wettwirtschaftliches Archiv, 133(2),pp. 313-329.

Organization of Economic Cooperation and Development, 2000, "Main Determinants andImpacts of Foreign Direct Investment in China's Economy," Working Papers onInternational Investment, Number 2000/4, December 2000,

Wall, D, BT Jiang, and X. Yin, 1996, China's Opening Door, London, the Royal Institute ofInternational Affairs.

Wei, S,, 1998, "Why Does China Attract So Little Foreign Direct Investment?" mimeo,Harvard University.

Wei, S., 2000, "How Taxing is Corruption on International Investors?" Review of Economicsand Statistics. 82(1), pp. 1-11.


-25 -

Zebregs, Harm, 2001, "Foreign Direct Investment and Output Growth in China," forthcoming.

Zhang, K., 1999, "EDI and Economic Growth: Evidence from Tea East Asian Economies,"Economic* Internazionale, November, 54(4), pp. 517-535.


Documents

PDP/02/3 - elibrary.imf.org · Author’s E-Mail Address: [email protected]; [email protected] 1 A version of this paper was presented at a seminar held at the Department of Industrial